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CHAPTER-V
PROJECT INVESTMENT EVALUATION
5.1 – Depreciation:

Definition

Depreciation is defined as the gradual decrease or loss in the value of the equipment
(asset) due to usage, passage of time and normal wear and tear.

Characteristics of Depreciation:

The following are the characteristics of Depreciation:

1. Depreciation is charged on fixed and tangible assets only.

2. Depreciation is a gradual decrease in the value of fixed assets. Fall in the value of current
assets are outside the purview of depreciation.
3. The gradual decrease is of permanent nature.
4. It is a process of allocation of cost of the asset over its useful life in a systematic way.
5. Depreciation represents only an estimate and not the exact amount.
6. Total depreciation cannot exceed the cost of the depreciable asset.
7. It is a non-cash charge and hence does not involve outflow of cash
8. Depreciation is different and distinct from amortisation, depletion, obsolescence,
dilapidation and fluctuation.
Classification of depreciation:

Depreciation

Depreciation due to Depreciation due to

physical condition functional condition

Wear and Physical Accidents Deferred Inadequacy Obsolescence

tear decay maintenance
and neglect
Depreciation due to wear and tear:

When any machinery performs work, wear and tear of the various components takes
place which can be minimized by taking precautions like proper lubrication and cooling. The
cost of replacing these components is the value of depreciation due to wear and tear.

Depreciation due to physical decay:

Some items get decayed because of climatic and atmospheric effects which
subsequently results in the reduction in the value of these items with the lapse of time.

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Accidental depreciation:

These are instances at which even after taking preventive measures to avoid accidents,
they are bound to occur due to mishandling or some other cause which results in heavy
damage.

Depreciation due to Deferred maintenance and neglect:

Every manufacturer issues certain instructions for the smooth and efficient running of
equipment. If these instructions are not followed due to neglect, improper maintenance reduces
the life of the equipment which is the value of depreciation caused by the above factor.

Inadequacy:

This form of functional depreciation means reduction in the efficiency of an asset over a
period of time even if properly maintained. Apart from this it may also be the cost of replacing it
with one of a higher capacity.

Depreciation by obsolescence:

Due to innovation or technological changes, a new machine may prove to be more

productive and efficient when compared to an existing one which pulls down the cost of
production. The cost of replacement required is the depreciation by obsolescence.

Need for providing Depreciation:

To ascertain true value of assets and financial position.

To calculate correct amount of profits or losses.
To make provision for replacement of worn_out assets.
To compute cost of production.
To comply with legal provisions of the Companies act.
To avail tax benefits.
Methods of Accounting depreciation: Most firms calculate depreciation in two different
ways
Book depreciation-the method of depreciation used for financial reports and pricing
products;
Tax depreciation-governed by tax legislation, the method of depreciation used for calculating
taxable income and income taxes.
Book depreciation
Used in reporting net income to investors and stockholders
Used in pricing decisions
Tax depreciation
Used in calculating income taxes for the internal revenue service
Used in engineering economics

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Value of an Asset :- Models of depreciation can be used to estimate the loss in value of an
asset over time, and also to determine the remaining value of the asset at any point in time.
This remaining value has several names, depending on the circumstances.
Market value:- is usually taken as the actual value an asset can be sold for in an open
market.
Of course, the only way to determine the actual market value for an asset is to sell
it.
Consequently, the term market value usually means an estimate of the market
value.
One way to make such estimation is by using a depreciation model that reasonably
captures the true loss in value of an asset.
Book value:- is the depreciated value of an asset for accounting purposes, as calculated
with a depreciation model.
The book value may be more or less than market value.
The depreciation model used to arrive at a book value might be controlled by
regulation for some purposes, such as taxation, or simply by the desirability of an
easy calculation scheme.
There might be several different book values for the same asset, depending on the
purpose and depreciation model applied.
Scrap value:- can be either the actual value of an asset at the end of its physical life
(when it is broken up for the material value of its parts) or an estimate of the scrap value
calculated using a depreciation model.
The Salvage value:- of an asset is an asset's actual/ estimated value at the end of its
useful life (when it is sold) or an estimate of an asset value calculated using a depreciation
model.
i.e. it is the amount eventually recovered through sale, trade-in, or salvage.
The eventual salvage value of an asset must be estimated when the depreciation
schedule for the asset is established.

Book Depreciation Methods it self classified in to different methods called Book Methods:
these are
Straight-Line Method
Declining-Balance Method
Double-declining-balance method
Units-of-Production Method ,
Sum-of-Years'-Digits Method ,
Sinking-Fund Method

Description of Book Depreciation Methods

Straight-line:- The book value of an asset diminishes by an equal amount each year.

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Declining-balance:- The book value of an asset diminishes by an equal proportion each

year.

Units-of-production:- Depreciation rate is calculated per unit of production as the ratio of

the units produced in a particular year to the total estimated units produced over the
asset's lifetime.

Sum-of-the-years'-digits:- An accelerated method, like declining-balance, in which the

depreciation rate is calculated as the ratio of the remaining years of life to the sum of the
digits corresponding to the years of life.

Double-declining-balance:- A declining-balance method in which the depreciation rate is

calculated as 2AV for an asset with a sendee life of N years.

Sinking-Fund Method:- This method depreciates an asset as if the firm were to make a
series of equal annual deposits (a sinking fund) whose value at the end of the asset's
useful life just equaled the cost of replacing the asset.

Straight line method:

This method assumes that the loss of value of machine is directly proportional to its age.
It is the easiest method to calculate and is mostly used in construction.
It is also known as ‘Fixed Installment Method’ as every year some fixed amount is
deducted and no consideration is made for maintenance and repair charges.
Depreciation amount per year,
C−S
D=
N

where, C is the initial cost of the machine, S is the salvage or scrap value, N is the number of
years of life of the machine

Example 1 - Cost basis of the asset (P) = 10,000 birr; Useful life (N) = 5 years; Estimated
salvage value (S) = 2,000 birr. Then Compute the annual depreciation allowances and
the resulting book values, using the SL depreciation method.
Solution:-
Given: P = 10,000, S = 2.000, and N = 5 years.
Find: Dn , and Bn, for n = 1 to 5.

The straight-line depreciation rate is 1/5 or 20%.

Therefore the annual depreciation charge is
Dn = (0.20)(10,000 - 2,000) = 1,600.
Then the asset would have the following book values during its useful life:
Bn, = P - (D1 + D2 + D3 + ... + Dn) or
where B, represents the book value before the depreciation charge for year n

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n Dn Bn
0 10,000
1 1,600 8,400
2 1,600 6,800
3 1,600 5,200
4 1,600 3,600
5 1,600 2,000

Example 2 A machine was purchased for .9,000 birr on 1st January,1981. The erection and
installation work costs .8,000 birr This was replaced by a new one on 31st December,2000. If the
scrap value was estimated to be 14,000 birr, what is the rate of depreciation and depreciation
fund on 15th June,1990? Life of machine = 20 Years

(i) If after 12 years of running, some assemblies are replaced at a cost of.17,000 birr, what will
be the new rate of depreciation?

Solution:

Total cost = cost of machine+ Erection & Installation charges

C =39,000 +8,000 = Rs.47,000
Scrap value, S = 14,000
Life of machine = 20 Years
C−S 47000 − 14000
Rate of depreciation, D = = =1,650
N 20
Depreciation fund on 15th June,1990, i.e, 10 installments could be accumulated.
Depreciation fund collected upto 15th June,1990,= 10 *1,650 =16,500
Book value in 12 years = 47,000 – ( 12 * 1650) =27,200
Replacement cost = 17,000
New book value = 27,000 +17,000 = 44,200 Birr
44200 − 14000
New rate of depreciation per year =
8
Example 3: A laser cutting machine was purchased four years ago for birr 380,000. It will
have a salvage value of birr 30,000 two years from now. If we believe a constant rate of
depreciation is a reasonable means of determining book value, what is its current book
value?
Solution(2) :- From the formula of SL depreciation method; with P = 380 000, S = 30 000, N =
6, and n = 4, we have:
P − S 380,000 − 30,000
Dn = = = 53,333.333
N 6
4
B4 = P − ∑ Dn = 146,667
1
Thus; the current book value for the cutting machine is birr 146 667.

Diminishing balance method:

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Also known as reducing balanced method, value of machine diminishes rapidly in

the early years and slowly in the later years.
In this method, the book value of the machine goes on decreasing as its existence
continues. A certain % of the current book value is taken as depreciation due to
which this method is called as ‘percentage on Book Value’ method.
If ‘X’ is the fixed % taken to calculate the yearly depreciation on the book value,
X = 1 – (S/C)1/N where, C is the initial cost of the machine

S is the salvage or scrap value, N is the number of years of life of the machine

Example 4: A lathe is purchased for 90,000 birr and the assumed life is 9 years and scrap
value is 25,000 birr. Using diminishing balance method, calculate the % by which the value of
the lathe is reduced every year and depreciation fund after 2 years.

Solution:

C = 90,000 birr
S =25,000 birr
N=9
X = 1 – (S/C)1/N
X = 1 – (25,000/90000)1/9 = 0.1326 = 13.26%
Value of lathe after 1 year = 10,000(1- 0.1326) = 8674Birr
Depreciation fund after 1 year = 10,000 – 8674 =1326 Birr
Value of lathe after 2 years = 8674 (1- 0.1326) = 7522.96 Birr
Depreciation of 2nd year = 8674 - 7522.96 = 1151.04 Birr
Depreciation fund after 2 years = 1326 + 1151.04 = 2477.04 Birr

Example 5: if the initial investment (P= BV0) is 100 and depreciation rate (r) is 40 percent,
then using declining-balance method the book value and depreciation charge will be as
follows for the first three years.
Solution:
Year Depreciation charge book value
0 - 100
1 100 (0.4)=40 60
2 100 (1-0.4)10.4=24 36
3 100 (1- 0.4) 20.4=14.4 21.6

Example 6:- Consider the following accounting information for a computer system:
Cost basis of the asset (P) = 10,000 birr; Useful life (N) = 5 years; Estimated salvage
value (S) = 2,000 birr and depreciation rate 40%. Find: Dn and Bn for n = 1 to 5.

Solution: The book value at the beginning of the first year is 10,000 and the declining-
balance rate a is 2 (1/5) = 40%.
Then the depreciation deduction for the first year will be 4,000 (40% x 10,000 = 4.000).
To figure out the depreciation deduction in the second year, we must first adjust the book
value for the amount of depreciation we deducted in the first year.

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i.e. The first year's depreciation is subtracted from the beginning book value (10,000 -
4,000 = 6,000).
This amount is then multiplied by the rate of depreciation (6,000 X 40% = 2,400).
By continuing the process, we obtain Dn Dn.
However, in year 4,, B4 would be less than S = 2,000 if the full deduction (864)
864) is taken.
Tax law does not permit us to depreciate assets below their salvage value.. Therefore, we
adjust D4 to 160, making B4 = 2,000. D5 is zero, and B5 remains at 2.000.

n Dn Bn
0 10.000
1 4.000 6.000
2 2.400 3.600
3 1.440 2.160
4 160 2.000
5 0 2.000

Years(SOY) Method
Sum-Of-the-Years(SOY)

Example 7 - A piece of equipment is available for the purchase for 12,000birr has an
estimated useful life of 5 years, has an estimates salvage valve of 2,000birr. Determine
the depreciation and the book valve for each of the 5 years using the Sum-Of-the-
Sum
Years(SOY) Method
hod and Double
Double-Declining-Balance(DDB) Method
Sum-Of-the-Years(SOY)
Years(SOY) Method:

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Year RL RL/15 Dn BVn

0 - - 0 12,000
1 5 5/15 3,333 8,667
2 4 4/15 2,667 6,000
3 3 3/15 2,000 4,000
4 2 2/15 1,333 2,667
5 1 1/15 667 2,000

Double-Declining-Balance(DDB)
Balance(DDB) Method

Year Dn BVn
5
∑D
t=1
0 - 12,000

1 0 0.4(12,000
0.4(12,000-0) = 4,800 7,200
2 0+4800=4800 0.4(12,000
0.4(12,000-4,800) = 2,880 4,320

3 4800+2880=7680 0.4(12,000
0.4(12,000-7680) = 4,800 2,592
4 7680+1728=9408 0.4(12,000
0.4(12,000-9408) = 1,037 2,000
5 9408+1037=10445 0 2,000

5.2 Equipment Replacement

• Engineers replace the existing equipment due to:
Obsolescence – technological change
Depletion – loss of market value
Deterioration – wear that is overly expensive to repair
Physical or mechanical impairment
Uneconomic or increasing maintenance and/or operating cost
Inadequacy – the required function can no longer be carried out economically
• Replacement analysis always iinvolve
nvolve comparison of an existing asset with a new one.
• Defender - the existing equipment previously implemented.

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• Challenger - the proposed replacement currently under consideration

• The defender would have been purchased some years ago at some cost say Po. Today
if it is traded in or sold because of a consideration to buy a challenger, the value
obtained will be lower say P
The term (Po – P) is called the sunk cost
cost.. The sunk cost is never taken into account in
engineering economic analysis.

Example 8: equipment which was purchased at a cost of 22,000birr four years ago is
considered for replacement against a challenger whose cost is 18,000birr. The existing
equipment can be traded in today at 6,000birr and if kept on for another 6 years, will
have a salvage
alvage value of 2,000birr. The annual maintenance cost of the existing asset is
7,000birr per year. The challenger has an annual operating cost of 3,500birr and its
salvage value 3,000birr at end of year 6, i = 15%.
Solution:
• Po = 22,000birr, P = 6,000bi
6,000birr and S = 6,000birr
• AEC(Defender) = 6000(A/P, 15%,6) + 7000 - 2000(A/F,15%,6)
= 8356.8birr
• AEC(Challenger) = 18,000(A/P,15%,6) + 3500 - 3000(A/F,15%,6)
= 7913birr
• Since the equivalent annual cost of challenger is less than the defender, it would be
economical to replace the existing equipment with the new equipment. This shows that
replacement is desirable.

Example 9 : Two years ago, an equipment was purchased at a cost of 200,000birr to be

useful for 8 years. Its salvage value at the end of its life is 25,000birr. The annual
maintenance cost is 25,000birr. The market value of existing equipment is 120,000birr.
Now a new w equipment is available at 150,000birr to be useful for six years. Its annual
maintenance cost is 14,000birr. The salvage value of the new equipment is 20,000birr. If
the interest rate is 12% find if it is worth replacing the existing equipment with the new
n
equipment.
• CFD for Defender

EAC = 120,000(A/P,12%,6)+25,000
120,000(A/P,12%,6)+25,000-25,000(A/F,12%,6)
= 120,000*0.2432+25,000--25,000*0.1232 = 51,104 Birr
• CFD for Challenger

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• EAC = 150,000(A/P,12%,6) + 14,000 – 20,000(A/F,12%,6)

= 48,016 Birr
Hence replace the existing equipment with the challenger.

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